Borrow From Your IRA or 401(k) With Caution
Written by: Kristy Welsh
Last Updated: August 1, 2017
401k's, IRAs and other pretax retirement savings accounts are now the most common ways to save for retirement, and millions of Americans pour money into them every year. In some cases, people commit too much money into their IRAs, without saving enough readily available cash for a rainy day. With economic conditions making it harder to borrow money these days, plenty of individuals are finding themselves searching for creative and sensible ways to finance life's wants, needs, and emergencies. Unfortunately, millions more take early withdrawals from these accounts due to hardship, loss of a job or other money woes. Is it a good idea to borrow money from your IRA or 401(k) account? Read on and get more information before you make this important decision.
Is it a Good Idea to Borrow From Your IRA?
The answers can be "yes" and "no" depending on various factors, but financial planners and tax professionals typically will offer virtually the same advice: If you can avoid it, don't tap into your retirement funds before your turn 59 years old, the age the U.S. government says is OK to begin withdrawals without incurring a 10 percent hit.
Additionally, it is important to understand the differences between borrowing and taking early distributions from an IRA versus a 401(k), as they are distinctly different animals. Both the IRA and the 401(k) are vehicles to save money for retirement, or occasionally for major purchases such as a child's college education or a down payment on a house. The principle difference between the two is that 401(k)s are retirement saving plans offered through your employer, and the IRA is a plan you set up on your own, with the help of a bank, or other financial agency. We'll look at each of these separately to help clarify these differences and hopefully help you understand the ramifications of borrowing, or taking early distributions, from either.
Information You Need Before Borrowing From an IRA
What is an IRA? An IRA is an Individual Retirement Account, and provides either a tax-deferred or tax-free way of saving for retirement. There are many different types of accounts within the world of IRAs, depending on the financial goals and circumstances of each individual, though traditional and Roth IRAs are the most common types. An individual is allowed to contribute up to a maximum value established by the IRS each year into the account(s). In return, you are required to wait until you are at least 59 years old to begin distributions. The penalty for withdrawal prior to this is 10 percent, so it's definitely not a good idea to withdraw early.
There are a number of exceptions to the rule that penalties apply to distributions before age 59. You'll want to visit the IRS website to obtain detailed regulations for each situation, but a summary of these exceptions is as follows:
- The portion of unreimbursed medical expenses that are more than 7.5 percent of adjusted gross income.
- Distributions to buy, build, or rebuild a first home. ($10,000 lifetime maximum)
- Distributions that are not more than the cost of medical insurance while unemployed.
- Disability which is defined as not being able to engage in any substantial gainful activity.
- Distributions in the form of an annuity, called substantially equal periodic payments.
- Distributions that are not more than the qualified higher education expenses of the owner or their children or grandchildren.
- Distribution due to an IRS levy of the plan.
- Amounts distributed to beneficiaries of a deceased IRA owner.
All of the above information deals with distributions, or withdrawals, from your IRA that can be done without penalty (but you will still be responsible for any income tax due).
Can You Take Out a Short-Term Loan? If you're only looking for a short-term source of money, and you can repay those funds within a 60-day period, then it can be done. It's called an IRA rollover, and the rules that govern it apply to both traditional and Roth IRA accounts. It's a relatively simple way to get your hands on a considerable amount of money without having to fill out a bunch of forms or pay any additional loan fees or other expenses, and you don't have to pay interest on the loan during that 60-day period. During that 60-day period, you'll need to ensure that you are able to secure a loan (or other source of permanent financing) in order to make the repayment, if necessary; the IRS is very strict regarding the 60 day window. Additionally, you can move funds from one IRA account to another, but not more than once in a 12- month period.
Nevertheless, the law allows you a 60-day grace period in which to move the funds. And, as it turns out, you aren't required to actually move the funds to another account; they can be redeposited back to the original IRA account and still satisfy the rollover provisions. Another key benefit to it is important to understand and be aware of is that you can elect to take these funds without the mandatory 20 percent withholding. It's the best of all possible worlds, as long as you get the money back into another (or the same) IRA account within the required 60-day period.
Information You Need Before Borrowing Money From Your 401(k)
What is a 401(k)? A 401(k) plan is a type of employer-sponsored defined contribution retirement plan under section 401(k) of the Internal Revenue Code (26 U.S.C.401(k)). A 401(k) plan allows an employee to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or deferred, into his or her 401(k) account.
Unlike IRAs, borrowing funds from a 401(k) can be arranged for periods longer than 60 days, but you are going to pay to do it. Not everyone's 401(k) plan will have a borrowing option, but the majority do. If it seems as though borrowing from your plan is your only option (and it should be your last option; not your first!), it is a relatively quick and easy type of loan to arrange, given that you are tapping into your own account, and therefore do not need to qualify for credit. Rules typically allow borrowing up to 50 percent of the vested account balance or $50,000, whichever is less. A consumer usually has a maximum of five years to repay the loan, unless the funds are earmarked for borrowing for a first home, in which case a longer payback will be allowable.
Advantages of borrowing from your 401(k):
- It's easy. Loan approval may be just a phone call away.
- No credit check. Given you have sufficient funds, the money is yours without worry.
- Relatively low interest rate. Usually lower than other types of loans, plus the interest is tax-sheltered.
Disadvantages of borrowing from your 401(k):
- It's easy. Yes, it may be too easy, and affect your attitude and ability to save in the future.
- If you quit or lose your job. The loan usually becomes payable in full, within 90 days maximum.
- Tax obstacles if you default. A default turns the borrowed sum into a 401(k) distribution, thus ordinary federal and state income taxes would apply plus the 10 percent penalty for those under age 59.
- You are losing investment interest. The net effect is that you have less money to invest and to earn interest. The money you borrow or take out of your retirement plan no longer appreciates in value from interest, dividends and/or capital gains in conjunction with the rest of your investment portfolio.
- It is not tax sheltered money anymore. Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars.
But let's go right back to the big question: Is it a good idea to tap into your retirement funds? Unless you absolutely have no other recourse, the answer is NO. However, we hope that if you do find yourself needing to do so, the information above will help guide you to make an informed, wise decision.